According to Investopedia: “A bubble is a market cycle that is characterized by the rapid escalation – i.e., exuberant market behavior – in the price of assets that greatly exceeds the asset’s intrinsic value.“ and …there are three components of a bubble.
- Valuation…[that] get dismissed or rationalized during the inflation phase…due to investor psychology and the “Fear Of Missing Out (F.O.M.O.) and
- Investor psychology
Jeremy Grantham posted the following chart of 40-years of price bubbles in the markets. During the inflation phase, each got rationalized that “this time is different.”
We are most interested in investor psychology. Charles Kindleberger noted that speculative manias typically:
- commence with a displacement that excites speculative interest,
- that then becomes reinforced by a positive feedback loop from rising prices
- which ultimately induces inexperienced investors to enter the market.
As the positive feedback loop continues and the euphoria increases, retail investors then begin to leverage their risk in the market as rationality weakens [as illustrated in the chart below that shows a dramatic interest in trading options].
During the mania, speculation becomes more diffused and spreads to different asset classes. New companies come to market to take advantage of the euphoria, and investors leverage their gains using derivatives, stock loans, and leveraged instruments.
This activity also aligns with the psychological phases that investors go through during a full market cycle [as shown in the chart of the historical cycle of market bubbles, below].
Near peaks of market cycles, investors become swept up by the underlying exuberance and that exuberance breeds the “rationalization” that “this time is different.”
…[We] know the market is exuberant when there is:
- High optimism
- Easy credit (too easy, with loose terms)
- A rush of initial and secondary offerings
- Risky stocks outperforming
- Stretched valuations
Let’s run through that list.
1. Exuburance? Check.
2. Easy Credit & Leverage? Check.
According to a recent survey from Magnify Money:
- Many consumers have taken on debt to invest with 40% of investors saying they have taken on debt to invest, including:
- 80% of Gen Zers,
- 60% of millennials,
- 28% of Gen Xers,
- and 9% of baby boomer investors.
- Personal loans were the most popular choice among those who took on debt to invest:
- 38% of those who went into debt to invest took out a personal loan, while
- 23% borrowed from friends or family.
- Many took on considerable debt to invest:
- 46% borrowed $5,000 or more.
3. Rush Of Initial Or Secondary Offerings? Check.
4. Investing In Risky Stocks? Check.
5. Stretched Valuations? Check.
...John Maynard Keynes once quipped that the “markets can remain irrational longer than you can remain solvent“ and such is the problem with trying to “time” a bubble, as they can last much longer than logic would predict.
George Soros explained the above well in his theory of reflexivity:
- “Financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality.
- The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced.
- When there is a significant divergence between market prices and the underlying reality, the markets are far from equilibrium conditions.
- When positive feedback develops between the trend and the misconception, a boom-bust process gets set into motion.
- The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception get reinforced.
- Eventually, market expectations become so far removed from reality that people get forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow, and more people lose faith, but the prevailing trend gets sustained by inertia.”
In simplistic terms, Soros says that once the bubble inflates, it will remain inflated until some unexpected, exogenous event causes a reversal in the underlying psychology. That reversal then creates a reversion in psychology from “exuberance” to “fear.”
What will cause that reversion in psychology? No one knows, but the important lesson is that bubbles are entirely a function of “psychology.” The manifestation of that “bubble psychology” manifests itself in asset prices and valuations.
Whether you agree a bubble exists is largely irrelevant. Every investor approaches investing differently. However, if you’re nearing retirement or are a retiree, your investment horizon is shorter than those much younger. Therefore, given you are less able to recover from the deflation of a market bubble, it may be wise to consider the possibility.
What you can do to navigate the bubble:
- Avoid the “herd mentality” of paying increasingly higher prices without sound reasoning.
- Avoid “confirmation bias.”
- Do your own research and avoid
- Develop a sound long-term investment strategy that includes “risk management” protocols.
- Diversify your portfolio allocation model to include “safer assets.”
- Control your “greed” and resist the temptation to “get rich quick” in speculative investments.
- Resist getting caught up in “what could have been” or “anchoring” to a past value. Such leads to emotional mistakes.
- Realize that price inflation does not last forever. The larger the deviation from the mean, the greater the eventual reversion will be. Invest accordingly.
Currently, investors believe “this time IS different” but “this time” is different only because the variables are different. The variables always are, but outcomes are always the same…The increase in speculative risks, combined with excess leverage, leaves the market vulnerable to a sizable correction.
Editor’s Note: The above version of the original article by Lance Roberts, has been edited ([ ]) and abridged (…) for the sake of clarity and brevity to ensure a fast and easy read. The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor. Also note that this complete paragraph must be included in any re-posting to avoid copyright infringement.
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